Japan - What Now?

The first months of 2007 have certainly seen some wobbling in the Japanese economy, or perhaps it would be more accurate to say in the monetary policy of the Bank of Japan; the economy actually has been muddling along quite nicely as per usual in recent months, driven largely by export growth and of course playing the much allured Japanese specialty of a tightrope game with deflation. So we recently saw the BOJ raise the overnight lending rate to 0.5% in a move which was both odd given the shaky character of some of the economic fundamentals and at the same time perfectly in line with the general perception that global interest rates need to move towards 'normalization' in order to scoop up excess liquidity. However, clearly 0.5% does not constitute normal in any meaningful sense of the word, at least not when it comes to the fundamentals for the carry trade it doesn't. So, what now for Japan? Well, If we look at the economic data we have seen so far for 2007 it is tempting to go for a 'steady as she goes' take and although I do believe that this view would not be too far from the truth I still think it is worth taking a bit closer look at the data we have in front of us.

An Economic Outlook on Japan - Watch that In(de)flation!

The first thing to note I think is that Japan entered 2007 with 0% inflation being registered in January, and this it should be noted was before the hike to 0.5% which was itself justified on the back of comparatively strong Q4 06 GDP figures. However it should be noted that the domestic component in the economy shows continuing signs of weakness and both retail sales and industrial production dipped in January. Retail sales in fact fell by 0.8% on a y-o-y basis, and this of course should not be seen as grave drop yet it does as always bring to the forefront the question of whether or not consumer spending in Japan really does stand before an imminent surge. Industrial production also dropped by 1.5% from December, with this fall being mainly due to de-stocking from the pre-January build-up. Expectations point to further de-stocking in February and perhaps even March although of course the widening export surplus may well provide some much needed relief here. Yet, once again there seems little correction in Japan's overall growth path and this of course raises questions about what actually can be done concerning Japan's growth imbalance, and about just how long we can carry on believing in the likelihood of a spillover effect from buyoant capital spending to the household economy.

In all of this the export sector naturally demands special attention since it is, at the end of the day, what drives the Japanese economy forward at the present time. Indeed the data (see link above) reveals a continuation of the impressive Japanese export performance as epitomized by the February figures which show that the Japanese external surplus widened a whopping 7.7% y-o-y on the back of impressive exports which grew at a rate of 9.7% y-o-y in February. Of course the immediate outlook for export performance (and thus also for capital spending) in Japan is in part clouded by continuing questions about the future of the US economy and just how the current slowdown will play out in Q1 and Q2 of 2007. So what should we expect from Japan going forward?

First of all we have the monetary policy question which is pretty sure to be at a standstill for the immediate and forseeable future (which in the present case means over the course of the coming summer).

Earlier this week the BOJ acted according to expectations and held rates at 0.5% on concerns that consumer prices might drop below zero, and this is a risk I also ascribe some weight to in my economic forecast on Japan. Also the recent announcement by the Fed in the US and the apparent move away from a tightening bias should provide an indication that global rates in the developed economies (save perhaps UK) might be getting close to their upper limit given economic fundamentals, and really I do think the ECB should take note here as well.

Another forthcoming data release from Japan may well point to changing sentiment in the Japanese economy as the Tankan business confidence survey is expected by many to fall back from a 2 year high, although it is worth noting here that there is far from a general consensus on this and, for example, Takehiro Sato from MS sees the Tankan survey in a somewhat different light. Once again the outlook of the US economy is bound to have a significant bearing on this.


The second important point to consider concerns consumer spending and more importantly the future course of inflation. Given the inflation data from January it is now almost certain that Japan will be flirting with deflation in February and March given the inbuilt downward trajectory in energy prices on a y-o-y basis. Whether this evolution in prices will be sustained is of course another story, but I am far from happy about potential developments in Q1 and Q2 and the possible feedback mechanisms with business and consumer sentiment that these may bring into play. On consumer spending, we have of course the recent drop in retail sales in January but on a m-o-m basis we should expect a pickup as the weather gets warmer and spring arrives. None of this will, however, change the underlying growth path of the Japanese economy which driven by capex which is in turn driven by foreign demand or, in other words, by exports. Lastly, and this perhaps is something which could modify the outlook I have sketched above, we have just learnt that land prices in Japan have risen for the first time in 16 years as appreciation in urban areas has finally outweighed depreciation in rural and provincial regions. Of course, this is once more prompting vigilance over at the BOJ where it is being interpreted as a potential forerunner of an asset bubble. Now, I think it is reasonable here to attach some qualifiers.

In the first place there seems to some be indication of speculation here, and especially in the big cities where the appreciation in property values is greatest and as such speculation needs to called what it is, namely speculation on further appreciation. Another interesting aspect is that a lot of the appreciation comes from overseas investors who are investing in Japanese property expecting to wheel-in a gain on future appreciation. Now, the overall property price level development is still substantially negative in Japan as shown here in the latest round up by the Economist on global house prices. I am not attempting here to deny the facts, but merely suggesting that the current speculation which is pushing prices up might be building on the back of expectations and a view of economic fundamentals which perhaps are not present in Japan.

The Yen and Carry Trades - Still Exciting

I cannot of course write any note on Japan without also doing a stop-off in FX-ville and take the latest pulse on the Yen and associated carry trade. The first observation to take away from the carry trade debate of recent months is that it is the volatility displayed by the Yen which has been prompting commentators on an on/off basis to hail the end of the carry trade. Yet, they have of course not been reading or not fully understood what Artim noted recently in his brief on carry trade. Of course I am not trying to say that that we should not be keeping a wary eye on the Yen and on the potential for unwind of the carry trade, but we should also do this whilst remembering that the recent day-to-day volatility has basically been driven by stock market and economic data from the US and elsewhere, and that the fundamentals have not really changed and neither have the expectations, at least not decisively. Of course, the minute expectations begin to solidify towards an appreciation of the Yen Japan will be in hell of a bind since an appreciating currency is associated with deflation which is also why I don't see the BOJ moving much further north on rates in a climate where the Fed is likely to be on hold and perhaps even move down on the back of downside risk of a recession in the US. However, none of this has happened yet which leaves Artim's analysis noted above pretty much right on cue. Now, there is more to a yen carry trade than going short on the Yen and as such what is the most likely long position which we can expect from, for example, your average hedge fund? Well, of course the USD is always an option but as Brad Setser notes in his very recent entry there is much more to this than meets the eye in terms of the choice of high carrying currencies which make the flip side of a carry trade.

In Summary

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis. On the carry trade I see no change in the fundamentals and indeed if the US economy edges further towards a recession and the Fed begins to ease I am not sure that this would cancel out the carry trade in any substantial way. The point is that Japan, at this point, cannot muster an expectations driven appreciation of the Yen as this would feedback into price levels with a deflationary impact. As such, I see a distinct risk for the BOJ heading back into ZIRP if expectations begin to drive the Yen up relative to the USD and the Euro.

Finally, I want to end on an open note in terms of Japanese interest rates and whether the BOJ should normalize or not. My impetus is a recent article in Bloomberg which cites forecasters Christopher Wood and Brian Reading, who are both ardent Japan watchers, as saying that Japanese should interest rates and do so rather sooner than later. Wood for example notes that the BOJ should raise immediately from the current 0.5% to 1.5% in one go. But, we could ask, where might the sanity in such move be located?

Wood and Reading say that higher rates will help banks increase the margin between loans and deposits. Meanwhile, real estate companies should benefit as rising household incomes spur investment in land and deflation's end helps property prices.

``The Bank of Japan should raise short-term interest rates in one go to 1.5 percent now, not incrementally,'' said Wood. ``The normalization of rates in Japan would create a colossal buying opportunity for the stock market.''

So where do I stand here then? Well, first of all I do see the predicament with current monetary policy in Japan since the interest rate pretty much represents a blunt weapon for the BOJ. However, I am not sure I buy the Wood and Reading's chain of arguments. What we need to consider is that any such abrupt move would almost certainly lead to the return of deflation - at least in the short term - and it is hard for me to see how this could push consumer spending higher even if equity markets saw a substantial appreciation. We need to remember Japanese demographics here too (strangely Wood and Reading do not include the marginal propensity to consume vs. saving anywhere in their analysis) and as such deflation coupled with substantially higher interest rates seem to represent a rather strengthened incentive to save relative to consume. Of course, goes the story, property prices would increase as well which together with equity market appreciation would represent enough savings for the domestic economy to put more money into consumption yet once again this is a strange prediction given the fundamentals of the Japanese with a median age of close to 43 and climbing. In the end however I am all for going against the conventional wisdom but even in a best case Wood and Reading's suggestion would represent some gamble not least with the BOJ's credibility and with Japan's ability to service a mounting public debt.

Finland's Economy - Last One Out Turn Off the Northern Lights?

Or still willing to shine?

By Aapo Markkanen: Tampere

If Joseph Schumpeter still lived, he would like Finland. Few other countries in the world have so thoroughly proved his point about creative destruction, which has it that the rise and fall of enterprises at the micro level, and national economies at the macro level is defined by how well and how soon they can adapt to change; by accepting that the operational environment is inherently evolutionary, and that the greatest art you can master is the art of letting go. It’s a lesson worth learning, and not least for the Finns themselves.

Finland, isolated by geography, started its industrial revolution rather late, at the end of the 19th century, and remained largely an agrarian society until halfway the 20th; when it became independent in 1917, 70% of the employed population was working in agriculture. Even if the step to manufacturing took its time, the next ones up the value ladder were less hesitant; yet brought about by the country’s own willingness to move on and to the evolutionary imperative - the dire circumstances of the early-1990s, that is.

Like other European market economies, Finland liberalised its financial sector at the beginning of the 1980s, which launched an intense credit boom, since borrowing wasn’t anymore a luxury reserved to the finest of society. In this case the policy was totally reactive, at best: out of fear of foreign capital, Finland had been Europe's laggard when it came to free its financial markets, and therefore couldn’t have the benefit of gradualism. As a result, the people went credit-mad and the banks, having been under inadequate scrutiny, lent them money for almost non-existent securities.

The boom and bust cycle came to an end around 1991, hence coinciding with the collapse of the Soviet Union - the destination for one fifth of Finnish exports - and doubling the trouble. For firms, bilateral bargaining with the mighty neighbour had been very favourable, so there had been no serious incentive to focus on the quality of products, or think "what's next". To make matters even worse, the Central Bank (previously a culprit of "playing Italian", i.e. granting a devaluation whenever the big exporters, namely the paper mills, and the affiliated trade unions, gestured for one), in search of credibility, had pushed for a stubbornly overvalued Finn Mark, and exports were not only of low quality but also far too expensive. When the recession was finally over in 1994, the country had lost about 14% of its 1991-level GDP and went from full-employment to a 20% unemployment rate.

Luckily, in the 1980s there had been some other issues that Finnish policy-makers had actually got right. As this paper (PDF) stresses, the policy of innovation underwent a healthy overhaul during that decade. The traditional public approach had been one of picking winners and investing money in them, whereas the Finnish government had understood - for reasons unknown, considering everything they did not understand - that innovation has more to do with micro than macro, and can merely be enabled, rather than directed. Following this vision, and along with the other Nordic nations, Finland was the first country in the world to open its telecoms market, thus allowing a company typically linked to the production of pulp, car tires and toilet paper to use it as an everyday laboratory. And as the mentioned conglomerate also took the risk of focusing on a product for which there were no mass market at the time, this all eventually paid off; Nokia was the first to move, and - once the recession had wiped off most of the low-value businesses - could as well find enough human capital to facilitate its expansion. Had politicians bailed out the old industries, this couldn't have been possible.

So if the water is already boiling, the frog (indeed, the Finnish parliamentary race isn't Europe’s only spring election) usually jumps out of the kettle. But that was fifteen years ago. How widely awake is Finland today?

First of all, it should be as awake as possible. Finland's median age is the world's fourth highest, exactly at 41 years. Total fertility is at Nordic levels, at 1.8 children, so the long-term situation is not as alarming as in most parts of Europe, yet the large number of baby-boomers will make it sure that roughly from 2010, and at least until the 2030s, Finns will have to live with the idea of constant austerity and growth levels on par with inflation, at best. If perceived in merely relative terms, the country's current public debt, presently 38% of GDP, may provide some relief - being rather modest by pan-European standards, and down from the 60% recession levels - but this, unfortunately, doesn't make its own straightjacket any looser. The debt level remains after all rather high, owing its shrinking largely to GDP growth rather than to actual debt settling. Hence spending the upcoming decades away won't be an option, and the next four years will be the last "normal years" for governing.

And if you use the mandate that is ending as a yardstick, the normal years have been good years. In 2006, the Finnish GDP grew by 5.5% (approx one per cent is a statistical mirage, due to a 2005 lockout in the paper industry) and is now $32.800, above Belgium and nearly even with Australia. Households saw their real income rise by 1.6%, which is partly thanks to some (arguably generous, considering the future) tax cuts introduced by the incumbent coalition. The overall taxation, in terms of GDP, is now at 43.5% and, if you listen to the OECD's advice, there's no fiscally sustainable way to push it lower; all decreases should be balanced by equal cuts in expenditure. As the safe margin has been exhausted, the OECD suggests instead that Finland should move from taxing incomes towards higher taxes on property (currently among Europe's lowest), yet such a maneuver wouldn't go down well among the electorate. It is a land where seven out of ten own their own homes - and, as you might guess, the remaining three that don't, have no political clout either.

The keenness of Finnish to own their homes, and the government's keenness to sponsor it, have also had their consequences for the labour market. The official, and somewhat fiddled, figures put the unemployment rate close to 7%, yet the regional disparities are dramatic. The prospering south and south-west regions, specifically the one surrounding Helsinki, are already suffering from a chronic labour shortage whereas declining areas in the east and north-east parts of the country sometimes have more than a fifth of their population jobless; and moving is, naturally, difficult if one has to sell property in a place where demand is low and then move to the booming capital.

Housing policy is definitely the only rigidity troubling the Finnish labour market. One myth about the so-called Nordic model is that of flexicurity, i.e. low job protection but high unemployment security. It may certainly be valid in Denmark, but Finland, or Sweden, are rather different cases, as you can see for example in this paper (PDF); in terms of hiring and firing Finland is more or less your average EU country - one that, moreover, has a long tradition of setting wages through collective agreements and universal pay raises. This has arguably contributed to containing inflation, and maintaining low income differences, but - by ignoring varying productivity levels - has also priced many low-skilled workers out of jobs altogether. Generally speaking, all these rigidities have not only led to a high-unemployment rate but also to an increasingly two-tier labour market, where a majority is enjoying well-protected permanent contracts and the worse-off minority has to combine one short-term or part-time post after another; as you can see from this PDF (and Chart 2.6), among OECD's EU members only Spain and Portugal have a bigger share of their workforce under temporary contracts.

Finland's total participation rate is nevertheless 70%, and has been on the rise since the government reformed the pension system in 2005. Prior to the changes, pensions were defined by the final salary of the retiree; in the new system it's the whole career that matters, and the working years from 63 to 68 have been made particularly lucrative. As concluded in this paper (PDF warning, again), for example, the reform can be considered a comparative success (namely in comparison to failed reforms e.g in France or Austria) but even then, it still left many problems unsolved - being "a new-entrant reform" and thus leaving the existing handouts untouched. (It is exactly cases such as this that made Peter Drucker to predict that intergenerational conflicts of interests will bring chaos to the increasingly obsolete political systems everywhere.) So the system has been tinkered with, but not fixed.

You can say the same about the education system, no matter how hard it has been benchmarked after the PISA results. To sum it up: the primary level does a good job with the young minds, the secondary level starts to waste their skills, and the tertiary level provides an equal distribution of mediocrity to everyone whose skills haven't been been wasted so far. You can read about the secondary level here, whereas the main problem of higher education is pretty simple: lack of money.

Universities were still adequately funded about ten years ago, but since then Finland has run into the same trouble as every other country that doesn't charge for tuition; if you don't allow the universities to collect their own money you must increase their public support by sums equal to inflation rates - and do it while the other services are also claiming for more money. It's nearly impossible. Also, if university revenues have no direct link to their own funding they will never get a true incentive to specialise or start competing with each other or, above all, their peers abroad. In other words, Finland has plenty of faculties that are "okay" or "good" but very little pockets of excellence. It can't make knowledge a business.

"Could be better, could be much worse" seems to describe best how Finland is like in the eve of demographic decline. Its macroeconomic prospects aren't as alarming as in most other developed countries (the point made by WEF's Competitiveness Reports year after year - it's the macroeconomy, stupid!) and it has indeed made an effort trying to make its welfare model sustainable. But is it enough? As it appears now, Finland is most likely to keep its head above the water but not much more. It will muddle through but it won't sparkle.

That is, unless it can learn some new tricks. The true lesson for Finland has been, after all, one of letting go. If Finns turn out to be as willing (or as forced) to change their ways as they have been before, they should do alright - assuming that their memory has not begun to fail them once they've grown older. If it indeed has, and Finns have grown complacent, then the future won't be too bright. The next four years will tell a lot.